Friday, March 20, 2015

Our first rental property

There are many different ways to invest your money, such as stocks, bonds, CDs, real estate, and more.  Currently, all of our investments are in index funds following the Boglehead 3 fund portfolio.  We’ve kept our asset allocation pretty simple over the last few years.  90% of our investments are in stock index funds (70% invested in domestic stocks and 30% invested in international stocks).  10% of our investments are in bond index funds. 

Rental property investing is something that I have always been interested in.  The wealthiest people and families I know made their wealth not from being doctors, lawyers, or accountants, but from real estate.  Two of my favorite bloggers, Mr. Money Mustache and Retire by 40 both have rental properties as a part of their retirement income stream.  This year, we are going to try our hand at rental property investing as a way to diversify our investments and income streams.

I have a few friends and colleagues who do real estate investing on the side.  One of my best friends has been investing in real estate properties for the last few years.  He is a buy-and-hold investor who owns multiple properties and makes money on the side from rental income, property appreciation, and tax deductions.  I went to him for help and consultation with getting started in real estate investing.  He has kindly given me a lot of tips and advice about getting into rental property investing.  The other day he said to me: “Imagine if you owned 10 paid off rental properties each providing $2,000 a month of cashflow… that’s $20,000 worth of income each month.  You’ll never need to work a regular job with that kind of income!”

Choosing the right property
Once we had the funds necessary for a down payment, we worked with a few recommended agents to vet out potential properties.  Real estate opportunities in Southern California are very limited, with high prices in the most desirable areas.  While you can buy sizeable homes for under $100,000 in various parts of the U.S. such as Ohio, Georgia, Illinois, or Florida - this same amount of money may not even amount to a down payment on a much smaller home in various popular cities around Southern California.  One absolute when it came to looking for a rental property was that it had to be within a reasonable driving distance of our home; we wanted to manage our own property.

We looked into several surrounding cities for potential cashflow positive properties.  We used sites such as to give us an idea of potential rental income as well as comparable prices for other recently sold properties.  Then we calculated all investment expenses such as mortgage, insurance, and property taxes.  We also determined the capitalization rate (“cap rate”) of every property that we were interested in.  The cap rate is the rate of return based on the expected income the property will generate. 

The cap rate is calculated by dividing the yearly income (after expenses) of a property by the total value of the property.

Cap Rate = (Yearly Income) / (Total Value)

The higher the cap rate, the better the annual return on your investment property.  More desirable locations will have a lower cap rate.  Looking at the cap rate is a quick “rule of thumb” way of comparing multiple opportunities.  In our local housing market, a cap rate greater than 5.0% is considered good.  In other less desirable neighborhoods, you might find properties with a cap rate greater than 10%.

Example:  Let’s say you are comparing two properties that are both on the market for $500,000, and Property A produces $25,000 income per year and Property B produces $50,000 income per year.

Property A cap rate: $25,000 / $500,000 = 5%
Property B cap rate: $50,000 / $500,000 = 10%

While determining a property’s cap rate is a good starting point to quickly evaluate multiple listings, other factors such as location and potential for future growth are also important.  What if Property A needs some maintenance and remodeling to make it a more profitable?  Also, what if Property B is in a location losing popularity?

Tax benefits of owning a rental property
When you own a rental property and receive rental income, this money needs to be reported on your taxes.  I was pleasantly surprised when I looked into the benefits of rental property tax deductions, which help reduce the taxes owed.  Turns out, rental properties provide more tax benefits than many other investments.  You can offset your rental income with expenses paid to prepare your property for rent, and also expenses paid to maintain your property over time.     

Making sure we take advantage of all deductions possible will help us with turning a profit on our first rental property.  I found this great list of top tax deductions for landlords at here.  Rental property deductions allowed by the IRS include:

Interest: Mortgage, credit cards, or personal loan interest payments on loans used to acquire or improve rental property.  Taxes and Homeowner association dues can also be deducted.
Depreciation: Landlords can get back the cost of a rental property through depreciation, deducting a portion of the cost of the property over several years.  
Repairs: Repairs to the rental property that are ordinary, necessary, and reasonable in amount can be fully deducted.  Repainting, cleaning, fixing floors, leaks, plastering and replacing broken windows are all deductible repairs.
Travel costs: Driving anywhere for the rental property such as driving to meet a tenant or going to a hardware store to purchase a part for a repair can be deducted.  You can deduct 50% of meal and entertainment expenses for employees.
Independent Contractors:  If you hire anyone to work on your rental property such as: repair people, construction workers, plumbers, electricians, carpet installers, painters, real estate management companies, or gardeners, you can deduct their wages as a rental property expense. 
Insurance: You can deduct the premiums you pay for insuring your property; such as fire, theft, flood and landlord liability insurance. 

Purchasing our first rental property
I’ve done a lot of reading with books, blogs, and the Bigger Pockets real estate forum.  Starting any new project can be daunting, especially one as big as rental property investing.  Although I can spend months and years just reading about it, the best way to learn is to jump right in and get started.  We don’t have delusions of getting rich quickly with real estate.  Quite the opposite actually; we expect this process to be slow with plenty of bumps along the way.  We will be thrilled if we can achieve steady growth. 

I am excited to share that we just closed on our first rental property a few weeks ago - a condo in a very nice gated association!  Getting approved for another mortgage at the best interest rate (4.0% for rental property) was easy since my credit score is so high.  Saving 50% of our take home pay and side hustle income will continue to give us a healthy financial cushion to take on this project.  Our regular income will allow us to reinvest any rental property income towards other real estate.  I’ll go over the property financials in a future post.    
Look at that tiny 1960s oven and range hood!  They have to go.

The spacing between the balusters is too wide and not up to code.  A new stair railing will be installed.

The property we picked up needs some remodeling, which we are currently working on.  My friend who has been mentoring me with real estate investing has referred a handful of the contractors that he uses.  We have also gotten many quotes from large companies, Craigslist advertised services, and family friends.  The quotes we have gotten vary considerably and are all over the place.  Some quotes were 3 times as expensive as others!  At the end of the day, we go with the people that seem to have the best work ethic and professionalism.  Seeing all the work slowly get completed has been very exciting.  While I haven’t done much DIY work personally, it still gives us a sense of accomplishment getting involved with the remodeling process.  This is definitely more hands on and tangible than simply buying a REIT index fund (which actually is very tax inefficient).       

This post was just scratching the surface of rental property investing.  We still have much to learn and will continue to share our progress along the way.

I documented the updates and remodeling we did to our property here.  
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